20 Aug Private or Government-Subsidized Student Loans?

I recently spoke with a prospective client whose only real financial problem was student loans. In this particular case, all of the student loans are private student loans. It is a bit unusual to see that; many people borrow from private lenders when their government-subsidized student loans are insufficient to pay all their educational expenses.

There are two significant disadvantages to private student loans–they almost always carry higher interest rates (12 per cent in this case), and they accrue interest from the time of the first advance. In other words, interest is being added to the balance while you are still in school. A government-subsidized student loan generally defers the interest until you are out of school.

I was curious why private loans had been chosen. Of course, my first thought was that this was the result of a financial aid officer steering loans to a preferred lender in exchange for a kickback. But that was not the case. So why did my client choose the more expensive option? It was easy to apply online, and no complicated paperwork was required. And, he did not understand either the difference between the private and government-subsidized loans, or how much it would cost in the long run. After all, he was still a teenager when he started college.

It is not surprising that someone so young would fail to understand the difference that deferred interest makes; after all, credit card companies’ stock in trade is the difficulty of calculating on the fly what interest on any given purchase actually costs. But here is an example. If you borrow $10,000 a year for four years of college, after graduation a deferred interest loan will have a balance of $40,000. The same $10,000 a year, at 12% without the deferred interest will have a balance of approximately $52,000 at the end of four years. Add to that the difference in interest rates, and you’re talking real money.

Both private and government student loans are nondischargeable in bankruptcy–i.e., they survive bankruptcy. (See Kent Anderson’s post on how much can be included under that umbrella.) The bottom line is that you are going to be repaying those loans, sometimes for as long as you would pay a mortgage. It’s important to understand what you’re getting into, and how much you’ll have to pay back. It also makes sense to keep student loan borrowing to an absolute minimum.